COMMENT: Is V4 convergence a mission impossible?

COMMENT: Is V4 convergence a mission impossible?
The share of automated jobs in the Czech Republic and Slovakia is the highest among the EU economies, because of car plants such as VW's Skoda in Mlada Boleslav.
By David Vavra of OG Research February 21, 2018

Over the last 20 years, the Visegrad Group (V4) economies have managed to close the initial gap in GDP per capita relative to Germany by some 20 percentage points, reaching only about 60% of German GDP per capita by 2016. At this rate, it will take another 40 years before German levels of income are reached. And should the convergence process slow down at higher income levels, as economic theory predicts, it may easily take close to a century.

The V4 economies fare even worse in relative wages. Annual average wages in purchasing power parity (PPP) terms have hovered around 50% of German levels in all V4 countries for almost a decade, irrespective of the various patterns in productivity growth and convergence. For instance, the average annual wage in PPP terms in both the Czech Republic and Slovakia in 2016 was at the same level relative to Germany as in 2009. Moreover relative wage levels are much lower than what would correspond to relative GDP levels overall (about 60%). Consequently a majority of people in the V4 economies have to work longer hours than their colleagues from richer EU economies.

Given the slow rate of progress, it can rightly be questioned whether convergence to German levels of income is a feasible prospect for the V4 economies at all. Judged from a historical perspective, the convergence benchmark for V4 might be at around 70–80% of German income levels. Practically none of the four countries has ever enjoyed more than 80% of German income levels in the past century.

An analysis published by Aspen Institute Central Europe a few months ago shows that the V4 convergence record indeed appears relatively slow, but this is a product of a very diverse experience within the V4 group. While Slovakia – the best performer – moved up by almost 30 percentage points over the last 20 years in GDP per capita to Germany, Hungary rose only about 12 percentage points.

Although all four countries moved up by around the same number during the first decade of 1996–2006 (between 12-16 percentage points relative to Germany), their success in narrowing the GDP per capita gap in the last decade has varied. For instance, the Czech Republic moved up by 14 percentage points over 20 years, but it has hardly moved at all in the last decade. Hungary’s position has even worsened – from 58% of German GDP per capita in 2006 to 57% in 2016. By contrast, Slovakia and Poland have kept up their progress, moving steadily in narrowing the income gap with Germany over the last twenty years. Indeed, Slovakia overtook the Czech Republic in terms of labor productivity (GDP per hour worked) almost a decade ago and remains the clear regional champion in that respect.

A positive feature of the V4 group convergence record is their success in sharing the economic wealth across the population and other dimensions of well-being. Above all, the level of income equality is outstanding. Slovakia is second and the Czech Republic fifth among the OECD countries in the Gini coefficient. Moreover, given their income levels, all countries display above-average levels of quality in physical infrastructure, health and education, enjoy relatively stable institutions and developed civic society, and have high environmental standards.

At the same time, though, it is clear that the zeal for institutional reforms from the 1990s has dissipated and the stock of physical infrastructure, social and human capital is advancing more slowly than expected based on income growth. It seems that especially the Czech Republic and Hungary face important structural barriers to growth.

With regards to the structure of the production, the V4 economies share several important characteristics. The first is the significant role of industry and manufacturing. At around 25%, the share of manufacturing in gross value added in the Czech Republic and Hungary stands at about the same level as that of Germany and well above the EU average of about 15%. The manufacturing shares in Poland and Slovakia are only marginally lower. This goes hand in hand with the prevalence of automated jobs. According to the OECD, the share of automated jobs in the Czech Republic and Slovakia is the highest among the EU economies, which makes them especially vulnerable to the robotisation of production.

Unlike in Germany, where automated production and a high share of manufacturing co-exist with high wages, the V4 economies have to do with a relatively low labor share of value added – below 40%, i.e. much lower than the approximately 50% in Germany. The low wages and labor share of value added in V4 economies probably reflect the specific nature of the capital-intensive production function in the V4 countries as well as foreign-dominated ownership. A large part of the value added is being repatriated abroad instead of being reinvested. This creates social tension and limits technological advancements in the production process.

The relatively fossilised structure of the V4 economies can also be seen in their relatively low value added production function. The V4 region has been rather pejoratively called the “assembly line of Western Europe”. For instance, the Czech Republic – still the richest in the V4 group, though no longer the most productive – has the lowest share of value added in gross production among all EU economies. Other V4 economies are doing only marginally better.

This picture of relatively un-innovative economies is reinforced by a number of international statistics tracking the attractiveness of the economy in various ‘soft’ categories. The V4 countries rank between 50th and 100th place in most indicators of the Global Innovation Index, such as university and industry research collaboration, R&D investments or e-government services. These characteristics do not indicate a very progressive and innovative production function.

According to Global Competitiveness Index (GCI) by the World Economic Forum, the main qualitative factors strengthening the competitiveness of the V4 economies are a stable and predictable macroeconomic environment, with a strong and developed financial sector. And yet, they are being bogged down by poor public institutions and labor market inefficiencies. Particularly troubling is the worsening capacity of the V4 economies to attract and retain talent. Unsatisfactory is the level of taxation, especially of labour. Dangerously negative tendencies have been observed in the burden of government regulation, the efficiency of the legal framework and the degree of favoritism by public officials.

In the absence of progress in these “soft” categories, the weight of the convergence process lies firmly on the low level of wages as the main source of external competitiveness. Unit labor costs in the V4 economies are comparable and have hovered at about 50% of German levels in the past decade. This can hardly endure forever without an incessant inflow of new workforce. Bringing in migrant workers to fill low-wage value added jobs – a strategy, which has been used to much effect in Singapore, South Africa and to a certain extent China – is however an unlikely option, given the current political climate in these countries and the EU as a whole.

The Aspen study concludes that considering the current production in V4 economies, based on relatively low-skilled manufacturing jobs and low value added, it is hard to imagine the German levels of income ever being reached. For such a leap in incomes, a totally new production function will need to be created. To that end, V4 will need to invest more in creating an environment conducive to new business and receptive to innovative technologies.

David Vavra is managing director of OG Research, a Prague-based economic consultancy. This article draws on his report "The Shape We’re In: Czech Republic & Central Europe", which was presented at The Aspen Institute Central Europe 2017 annual conference in November.